NOTE

Is the Risk Free Status of Euro Area Sovereign Debt in Tatters?

In the first week of March, the euro area experienced the biggest sovereign debt restructuring in history and the first ever triggering of sovereign credit default swaps (CDSs) for an industrialized country. Yet nothing happened after these events struck Greece. It was a market non-event that was fully anticipated. For the often maligned euro area crisis strategy of “kicking the can down the road,” the events were an extraordinary vindication and success because nobody cared when Greece finally did default. Of course, we don’t know what the counterfactual would have been if Greece had defaulted in May 2010 or July 2011 — if banks might have failed or markets might have frozen. As a result, euro area leaders will undoubtedly be subject to an iron law of politics: You never get any credit for avoiding a worse scenario. Meanwhile, many analysts (not including yours truly) can now feel vindicated by correctly predicting an eventual Greek default early on.

For Portugal, Another Program is Likely

With the risk free status of euro area sovereign bonds widely seen as in tatters, where does the euro area go from here? The euro area has repeatedly maintained that Greece is a unique case and that euro area sovereign bonds should still be considered as without credit risk. Needless to say, private bond investors are likely to take some persuasion before they will accept that argument. The key issues concern Portugal and Ireland, which like Greece are removed from the markets and reliant on International Monetary Fund (IMF) programs. They are scheduled to return to the markets in late 2013. Irish five-year bond yields are currently at 5.25 percent, indicating that the ability to refinance Ireland’s debt at affordable and sustainable rates with private creditors is not that far off. Comparable Portuguese five-year rates, on the other hand, are at 16.75 percent, suggesting that Lisbon remains far from regaining private bond investors’ trust.

Superficially, this enormous yield differential might seem strange. Both Ireland and Portugal have just received good remarks from the IMF for the implementation of their programs. Portugal’s immediate growth outlook and structural economic problems, which are far worse than Ireland’s, clearly play a role. However, it looks like Portugal’s somewhat worse economic outlook is amplified by the markets’ desire to see the euro area back their claim of Greece’s unique status with sufficient financing for other troubled countries. Ironically, Portugal’s compliance with its IMF program, entitling it to more official sector financing, means that it cannot now regain private financing access.

Because of the deep structural nature of its problems, Portugal is unlikely to return to strong growth for at least a couple years. Portugal can regain some confidence by getting another fully IMF program without any write-down of its private debt, or private sector involvement (PSI). Apart from Greece, Portugal probably has the worst economic fundamentals in the euro area. It will thus be the test case that markets will use to see whether the euro area is serious about banishing the future use of private sector haircuts. The euro area is caught in a bind. Without having first finished a new Portuguese program, European leaders cannot credibly banish the Greek PSI stigma from Portugal on the way to restoring the risk free status of euro area sovereign bonds. Barring an unlikely Portuguese economic miracle, a new program without PSI for Portugal is certain later in 2012.

For Ireland, Lingering Concerns Over the Seniority of Creditors

The case of Ireland is less straight forward. Since it is relatively close to regaining market access, presumably a modest additional dose of financial assistance from the euro area would secure such access. Ireland’s persistent adherence to its IMF program presents the euro area with an interesting timing issue: Write Ireland another relatively small check now to virtually ensure market access in 2013, or risk having to fully fund another Irish program later on. As I have discussed before, the planned referendum in Ireland on the Fiscal Compact Treaty in a few months might help persuade the euro area to strike a deal now on the difficult and complex technical issues like the refinancing of the promissory notes given to Anglo Irish Bank in 2010.1 (Note this is usually euro code for a stealth fiscal transfer.)

Meanwhile, providing more euro area funds to Portugal and Ireland aggravates lingering market concerns over the seniority structure of the remaining sovereign debt. At present, private creditors might fear becoming ever more subordinated by growing official sector debt. As a result, giving Portugal a new wholly euro area funded program to show that PSI is off the table might ironically increase the perception of riskiness of Portuguese debt for some private investors. These investors are still not certain what the euro area might do in the future.

A new wholly funded program without PSI for Portugal might not improve its market access for longer-term debt. Whether additional IMF funding to Portugal can be secured beyond the current program is an open question. Given the structural nature of Portugal’s economic challenges, which will with certainty take several years to improve, as well as these lingering effects of Greek PSI, at least the euro area looks set to provide its financing for Portugal for a long time even if Lisbon does all its homework. The fact that the euro area will consequently likely end up having to finance Portugal even if it — as seems likely — successfully “does all its homework” is important. Even euro area members that undertake successful reform may need future financial support. The issue of seniority for creditors is different for Ireland’s promissory notes. The Irish government is essentially asking that the expensive debt issued by the National Asset Management Agency (NAMA) bad bank in 2010 (to recapitalize the Anglo Irish Bank and other troubled banks) be restructured at less expensive interest rates. This step would save money for NAMA and improve the Irish net government debt position. Such a restructuring will not raise any seniority concerns like those that hit Portugal, because no new official sector debt will be added. Instead, the cost of Ireland’s current debt would be reduced. Consequently, the euro area should without delay grant Ireland a deal on these promissory notes. Having to finance a new Irish program would raise the seniority concerns affecting Portugal.

For Greece, Fears of Another ‘Default’

Then there is the issue of Greece’s new long-term bonds, thrust on the country’s hapless private creditors in last week’s coercive bond swap. They have begun trading at north of 20 percent yields. In what is probably an illiquid market, these yields suggest that markets expect a second Greek default against private creditors. The question, however, is whether this is a foregone conclusion, even if Greece requires additional euro area funding. If Greece ‘defaults’ again, requiring more euro area taxpayer money, why would the euro area force another default on private creditors? Coupon payments are merely 2 percent on the new bonds until 2015, so the cash savings of defaulting on these bonds during the next 3 years would be relatively small.

Meanwhile, such a default would undoubtedly result in further losses in the euro area banking system, where most participating banks probably book these new bonds at their par value. Such losses would not likely be in the general interest of euro area governments. Their banking systems will still be adding to risk capital levels in coming years. Moreover, a second Greek default against private creditors would further undermine any notion of risk free status for sovereign euro area bonds, reigniting potential contagion to other markets. Renewed contagion would make a mockery of attempts to restore the market credibility of euro area sovereign bond markets.

The only scenario in which another default against remaining private Greek creditors and their newly swapped bonds will be sanctioned by the euro area is one in which Greece exits the euro. (Note that Greece, which is living with a euro area-sponsored escrow account, no longer has the fiscal sovereignty to declare such a default independently.) As discussed earlier, that risk is not zero. A future populist Greek leadership might seek an exit to safeguard national sovereignty, despite what would be an accompanying economic disaster. The prospect of an exit is also not nearly as high as current Greek bond yields suggest, however. Greece’s new bonds will not likely exist until the last ones are redeemed in 2042. More likely they will be converted into eurobonds, perhaps in 20 years, rather than be defaulted against again.

For the Euro Area, Markets and Political Leaders Misunderstand Each Other

Breaking the risk free taboo of sovereign bonds have stirred fears of irreparable damage to the euro area debt markets and caused their cost of capital to rise. But euro area leaders say they are determined to restore pre-PSI status quo of euro sovereign debt.

Ironically, euro area leaders’ insistence on PSI for Greece might have created a self-fulfilling prophecy with respect to the loss of risk free status of their sovereign debt. Markets prefer not to have to think hard about such complex issues. They prefer the analytical shortcuts conferred by market conventions about “risk free status” or rating agencies that have too easily granted AAA-ratings because the markets then avoid the trouble of making their own proper risk assessment. The status of sovereign debt for years as “risk free” gave the markets a misleadingly convenient benchmark by which to price all sorts of other financial assets.

Eliminating the sacrosanct risk free status of their debt has exposed euro area leaders to the markets’ myopia and simplistic understanding of euro area politics. Current euro area economic research from various investment banks is full of long-term political judgments like this: “PSI cannot be ruled out at a later stage. As time goes by, reform fatigue may become a problem and support for more radical political parties may emerge.”2

One has to wonder about the empirical foundation for such purely political pontification by Wall Street and City of London economists. This weekend in Slovakia, the pro-euro center-left Social Democratic (SMER) party won an overwhelming electoral victory, securing an absolute majority in parliament. The far-right populist Slovak Nationalist Party (SNS) failed to clear the parliamentary threshold. After elections across the euro area periphery in Ireland, Portugal, and Spain, one has to ask: Where are the storied euro area populists actually coming to power? Upcoming Greek elections represent a new risk of populist gains, but such an outcome would go against a broad-based trend, setting Greece ever more apart from the rest of Europe.

The Greek PSI, along with long-lived Anglo-Saxon stereotypes about the 1930s in Europe and the emergence of the US Tea Party, have all fed into the financial markets crying wolf about populists taking the reins of power. The wolf remains off in the distance, if it exists at all.

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